Exchange trading of mutual funds or other portfolio basket products

ABSTRACT

A system for determining a basket of financial instruments for hedging investment risk in actively managed exchange traded funds is described. The system uses a trusted computer system and includes a computer storage medium storing a computer program product. The product determines the basket of hedging instruments by extracting factor information from a portfolio of the actively managed exchange traded fund and determining factors that affect the price of the exchange traded fund. The program can select a portfolio of instruments with similar behavior with respect to the determined factors to produce a hedging portfolio that tracks the price of the exchange traded fund.

BACKGROUND

[0001] This invention relates to hedging techniques for exchange tradedfunds or similar basket products.

[0002] Exchange traded funds or basket products such as S&P 500Depository Receipts (SPDRs) are vehicles for holding a basket ofsecurities that can be traded on an exchange or securities market. Morespecifically, these instruments usually represent an undivided ownershipinterest in a portfolio of stocks or other securities held by a Trust.The portfolio of stocks is often intended to track the performance of anindex like the S&P 500 Index, and therefore seeks to investsubstantially all of its assets in the stocks comprising the S&P 500index, in proportion to the relative weights of stocks in that index.SPDR shares are securities issued by the SPDR Trust and may be traded ona stock exchange or in over the counter transactions.

[0003] The intra-day pricing of such securities is determined by supplyand demand. Typically, these SPDR fund shares may be created or redeemedat the end of each business day at a net asset value price in so called“creation units”. In the case of the SPDRs the creation unit has 50,000SPDR fund shares. SPDR creation units are created or redeemed at the endof day net asset value through an in-kind transfer of securitiescorresponding to the S&P 500 index. While the official net asset value(NAV) of the SPDR Trust is only published at the close of every businessday, the estimated value of the underlying S&P 500 index and the valueof the creation basket are published continuously throughout eachtrading day. The per SPDR value of the index and/or the creation basketcan be devised and distributed electronically to brokers, dealers, andinvestors throughout the world.

[0004] An intra-day value disseminated by the exchange is a real timecalculation designed to give an investor a per share price which is veryclose to what the intraday net asset value would be, if it werecalculated. At the end of trading, the intraday approximate calculationand the official NAV should be nearly identical.

[0005] Intraday values of exchange traded trusts such as SPDRs or mutualfunds such as the Select Sector SPDRs may be evaluated from the publiclyavailable creation basket or the index on a per share basis throughoutthe day as if the creation basket or the index were the portfolio of thefund. The calculation is relatively straight forward, since the creationbasket composition changes little from day to day unless the indexchanges. While the fund may contain proportionately a few more shares ofone stock and a few less of another stock than would be provided bymultiplying the creation basket by the number of creation baskets thatconstitutes the fund, the calculation is very close to net asset value.

[0006] Trading on exchanges such as the America Stock Exchange involvesa trader called a specialist. A specialist tries to match buy orderswith sell orders in a manner that maintains an orderly market. Oftenspecialists and market makers (who make markets for securities onexchanges or on electronic markets such as The Nasdaq Stock Market andwho have obligations similar to but less demanding than those of thespecialists to help maintain an orderly market) will have to take acontrary position to the prevalent position in the market by placingtheir own capital at risk. In securities markets, during the course of atrading day, there can be a net demand for a security, e.g., an exchangetraded fund. Thus, over the course of a trading day, the specialist andany market makers trading the security can be selling more shares of asecurity than they are buying. In this situation, the specialist mightbuy components of the fund or derivatives based on the fund or on anunderlying index in order to hedge its position. If the specialists andmarket makers have bought more shares of a security than they have sold,they might sell short components of the fund or associated derivativesto hedge their positions.

SUMMARY

[0007] For actively managed exchange traded mutual funds the compositionof the fund may not be known to the market maker or the specialist andhence hedging against a creation unit basket or an index such as the S&P500 may not be effective, since the fund may behave very differentlythan the creation unit basket or index. Since there is no correspondingsecurity or index or alternative fund with which the specialist ormarket maker can hedge a position, trading in such actively managedfunds is more difficult than trading a fund based on a known index.

[0008] According to an aspect of the present invention, a method ofhedging investment risk in actively managed exchange traded fundsincludes extracting factor information from the portfolio of theactively managed exchange traded fund and determining factors thataffect the price of the exchange traded fund. The method also includesselecting a portfolio of financial instruments with similar behaviorwith respect to the determined factors to produce a hedging portfoliothat tracks the price of the exchange traded fund.

[0009] According to an additional aspect of the present invention, acomputer program product residing on a computer readable medium forhedging investment risk in actively, managed, exchange traded fundsincludes instructions to extract factor information from a portfolio ofthe actively managed exchange traded fund, determine factors that affectthe price of the exchange traded fund and select a portfolio offinancial instruments with similar behavior with respect to thedetermined factors to produce a hedging portfolio that tracks the priceof the exchange traded fund.

[0010] According to an additional aspect of the present invention, acomputer system for determining a basket of securities or otherfinancial instruments for hedging investment risk in actively, managed,exchange traded funds includes a trusted computer system and a computerstorage medium. The computer storage medium stores a computer programproduct including instructions to extract factor information from aportfolio of the actively managed exchange traded fund, determinefactors that affect the price of the exchange traded fund and select aportfolio of financial instruments with similar behavior with respect tothe determined factors to produce a hedging portfolio that tracks theprice of the exchange traded fund.

[0011] One or more of the following advantages may be provided by one ormore aspects of the invention.

[0012] The specialist and market maker (each hereinafter referred to as“trader”) are provided with information that enables them to buy or sella specially constructed hedging portfolio that behaves in a very similarway to the underlying fund shares. The specialist and market makers areprovided with information that will be helpful in creating a hedgingportfolio to help them make markets with narrower spreads with goodcontrol of their risks.

BRIEF DESCRIPTION OF THE DRAWINGS

[0013]FIG. 1 is a block diagram of a computer system to perform an intraday net asset value proxy calculation.

[0014]FIG. 2 is a flow chart showing a process to determine an intra-daynet asset value proxy of an actively managed fund.

[0015]FIG. 3 is a flow chart showing a portfolio adjustment process.

[0016]FIG. 4 is a flow chart showing an embodiment of an intra-dayvaluation process for an actively managed fund.

[0017]FIG. 5 is a flow chart showing a process for producing a hedgingportfolio for an actively managed exchange traded fund.

[0018]FIG. 6 is a flow chart of an alternative hedging process for anactively managed exchange traded fund.

[0019]FIG. 7 is a flow chart showing an alternative process forproducing a hedging portfolio for an actively managed exchange tradedfund.

DETAILED DESCRIPTION

[0020] Referring now to FIG. 1, back room operations of an exchange 10,an electronic market and so forth are shown. The operations 10 include acomputer system 11, which includes a CPU 12, main memory 14 andpersistent storage device 16 all coupled via a computer bus 18. Thecomputer system 11 may be a server as shown, which is coupled in anetwork of computers in a conventional manner such as in a client-serverarrangement. The details on the client server arrangement are notimportant to understand the present invention. The computer system 11can also include output devices (not shown) such as a display and aprinter, as well as input user interface devices (not shown) such as akeyboard and a mouse. The computer system 11 also includes a networkinterface 20, that couples the computer 11 to a network 24. The computerback room operation 10 also receives a quote feed from a quote server 26and portfolio information from a computer 28 associated with an activelymanaged fund.

[0021] The computer system 10 receives information concerning real-timeprices of securities from the quote server 26 and information concerningcomposition of portfolios from the fund computer 28. The computer system11 also includes intra-day NAV proxy algorithm software 40 thatcalculates in real time an intra-day net asset value proxy for anexchange traded fund, in particular for actively managed funds orenhanced index funds. Examples of other products that can use anintra-day NAV calculation can include the value of a spot commodity poolor futures pool; a basket of fixed income instruments chosen for theiryields, average maturities, specific durations, the currency in whichthey are denominated, or for other reasons or characterizations.

[0022] Referring now to FIG. 2, a process 40 to determine an intra-daynet asset value proxy is shown. The process 40 can be used to calculatean intra-day NAV proxy for an actively managed portfolio or an enhancedindex fund over the course of a trading day. The calculation can beperformed in real time. The process 40 will be described in conjunctionwith an actively managed mutual fund. Once the closing portfolio isrevised for the day's transactions, or more accurately, the next day'sopening portfolio on which the intra-day NAV proxy and the officialclosing NAV will be calculated, has been determined and checked foraccuracy by the portfolio management organization, the portfolio isencrypted and transmitted to the intra-day price calculation (42).

[0023] The net asset value process 40 receives 42 in an encrypted formatfrom the portfolio management organization. This portfolio informationhas been adjusted to reflect any transactions made on the prior tradingday (T−1). Official net asset value calculations that are disseminatedto the general media after the close of trading on a current trading day(T) are based on the position of the fund at the close of the priortrading day (T−1). The net asset value is calculated on current day (T)as if no trades occurred during the trading day. In general, thisconvention makes little difference in the overall net asset valuecalculation of the fund because it is unusual to have a combination ofmassive turnover on a single day and a significant difference in priceat which shares are sold on a current day and the closing price at whichthe fund is priced. The portfolio is also adjusted to take intoconsideration other factors such as dividend credits and expensesattributable to the current day (T). In other embodiments, the actualclosing trade date positions of the fund on the current day can be usedin the calculation.

[0024] The portfolio information is decrypted 44 and the information isused as the template for intra-day calculations. As a check, a closingprice tape identical to the tape used in pricing the basket as of theprevious night's close, can be fed to the template to determine if thenet asset value calculated against the template is identical to theprevious day's closing NAV plus or minus known adjustments. Thedecrypted portfolio can be re-encrypted using the same or a differentencryption process and returned to the portfolio management organizationwhere it will again be decrypted and compared with the file originallysent. This process is used to make sure that the file was not corruptedin the original encryption and transmission process. Other checks arepossible including error correction, unauthorized use detection,checksums, etc.

[0025] The portfolio information file is encrypted using a publicencryption key of a public-private key encryption algorithm with thecorresponding private key being only known by the net asset value proxycalculation process 40. The received portfolio data is decrypted in thenet asset value proxy calculation process 40 using the correspondingprivate key. A portion 41 of the process 40 is executed within a socalled “trusted system”. Trusted systems refer to a physical hardwareand operating system configuration in which domain configuration andtrust relationships are established to determine access to informationon the computer 11.

[0026] A trusted computer can have the capability to recognize anothertrusted system, to execute usage rights (in this case access rights forthe portfolio information file) and to render the file so that it cannotbe copied or sent in decrypted form outside of the process 40. A highlysecure channel can be established between the computer 11 and the fundcomputer 28 to enable a transaction where the two trusted systemsexchange data over a communication channel, e.g., the Internet or aproprietary network feed, providing assurances to the fund computer 28that it is in fact communicating with the exchange back room operationcomputer 11. Communications over a secure channel can be accomplishedwith encryption and what are known as challenge-response protocols.Other techniques are possible.

[0027] The computer system 11 would have a trusted relationship where arights or privileges policy is established such that the decryptedportfolio file cannot leave the intra-day net asset value proxy process40 in a decrypted form. That is, only the intra-day net asset valueproxy process 40 itself is given privileges to access the data in thefile and no copies can be made of the file. The file may reside in thesystem throughout trading until replaced with a new file for calculationof intra-day net asset value on the next trading day (T+1). At that timethe file can be re-encrypted and returned to the actively managed fundor destroyed.

[0028] The process 40 matches 46 quotes from a quote feed to stocks inthe portfolio throughout the current trading day (T). The process 40calculates 48 a new net asset value proxy for the fund by applyingreal-time quotes received from the quote server 26 to positions in thefund portfolio. The process 40 can disseminate 50 a net asset value forthe fund on a periodic or continual basis throughout the day.

[0029] Referring now to FIG. 3, a portfolio adjustment process 60 usedto assemble a fund portfolio to send to the intra-day net asset valuecalculation process 40 is shown. Portfolio adjustment process 60 adjusts61 portfolio positions to take into consideration any trading thatoccurred on the previous trading day (T−1). These positions in theportfolio are further adjusted 62 for dividend credits attributable today (T), as well as adjusting 64 for any expenses attributable to day(T). Cash positions (not shown) are also taken into consideration. Theadjusted portfolio is assembled into a portfolio file and includesadditional information such as the total number of shares outstandingfor the fund or basket, e.g., to quote vendors, and so forth. Theportfolio file is encrypted 66 using the public key of thepublic-private key algorithm used in the process 40. The portfolio istransmitted 68 to the back room operations 10 of the exchange or marketwhere it is received 42 (FIG. 2) and used as described in conjunctionwith FIG. 2.

[0030] Referring now to FIG. 4, an embodiment of the intra-day valuationproxy process 40 for an actively managed fund is shown. The process 40decrypts 44 a the portfolio file, as received from the fund manager, andpopulates 44 b a table 44 c with fund positions. The table 44 c caninclude, for example, security symbols, quantity of shares held and anindication of whether the position in the shares is a “short” positionor a “long” position and so forth.

[0031] The process 43 continually receives 45 quotes or transactionprices from the trade and quote feeds and determines 46 whether acurrently received security and price corresponds to a security in table44 c and thus is a security in the actively managed fund. If thesecurity and price does not correspond to a security in the table, theprocess waits 47 to examine the next new security and price. Otherwise,the process 40 will calculate 48 a a new value of the position (and itsbid and offer if the price is a quote rather than a transaction price ofthe security) as of the trading day by, for example, retrieving thenumber of shares in the position and multiplying the number of shares bythe current quote for the security. This new value will replace 48 b, aprior value for the position in that security. The process 43 willcalculate 48 c, a new net asset value proxy and/or new bid or offer ofunderlying instruments, by taking the sum of the values of all currentpositions in the fund and dividing that by the total number of sharesoutstanding in the fund.

[0032] Another technique that can be used to calculate the net assetvalue proxy would have the portfolio table 44 c include another fieldthat has the value of the position on day (T−1). The table could alsohave a total of all positions. The net asset value proxy calculationwould take the total valuation of the fund, subtract the old value ofthe position for a security and add the new value of the position forthe security into the total. The new sum would be divided by the numberof outstanding shares. The new, net asset value proxy calculation isdisseminated 50 through the exchange to quote vendors.

[0033] With this intra-day net asset valuation proxy process 40, a stockexchange can calculate in real time, intra-day net asset value proxiesfor actively managed and enhanced exchange traded funds. Portfoliomanagers are assured that the positions of the fund are not knownoutside of the fund so that others, e.g., traders and competitors willnot know what securities the fund is buying and selling. This isimportant to maintain a fiduciary duty to keep positions confidentialwhere confidentiality is in the interest of the shareholders of thefund. Thus, this technique assures confidentiality while enabling thesystem 10 and, the backroom computer 11, to give investors up-to-date,i.e., real time information on valuations to facilitate trading in themutual fund or trust instrument. Maintaining the confidentiality of thisknowledge is important because public dissemination of the informationmay enable individuals and organizations in effect to trade against thefund. This confidentiality is assured by encrypting the file and onlyproviding the software with the decryption key to decrypt the portfolioposition information in the file.

[0034] The portfolio information is only available to the net assetvalue proxy calculation internal to the computer. The information iseither re-encrypted or destroyed so that unauthorized access isprevented. This provides a process for determining an intra-day NAVproxy for actively managed or enhanced index funds that protects theinformation that the fund manager transmits to the intra-day NAV proxycalculation server.

[0035] A real time calculated net asset value proxy disseminated to themarket may provide several advantages to the market. The real timecalculated net asset value proxy can help establish tight valuationranges (e.g., lower spreads between bid and ask) which may lead to tightpricing in markets for the basket of securities used to establish thefunds. To the extent that trading in the basket would facilitate theformation of more units of the basket, i.e., creation of additionalunits of an exchange traded fund or additional units of a commoditybasket, etc., the cost of maintaining and operating the basket orportfolio would be spread over a larger pool of assets. Consequently,the costs per-dollar of assets in the portfolio or basket might bereduced.

[0036] The backroom computer 11 on which the NAV calculation isperformed should have appropriate testing procedures for evidence oftampering with software, hardware or data files or access byunauthorized persons to provide a high degree of both physical and datasecurity during the period the decrypted portfolio file is in use in thecalculation of intra-day Net Asset Value Proxies. The use of dualprocessors or systems; for redundancy i.e., fault tolerance, would alsobe appropriate. In addition to improving reliability, a fault tolerantsystem can facilitate management of the system if there is a problem inthe calculation module. The ordinary steps that the management of asystem installation could take to repair a hardware or software problemmay be rendered more difficult by the encryption-decryption process andby the protections built into the processor. In other words, both thehardware and software may be less accessible than they would be in anormal installation.

[0037] Another aspect of the calculation is that it can provide in thecontext of an actively managed fund bid and offer values and a spread interms of the fund intra-day NAV proxy. While the calculation generallyis comparable in every material respect to the traditional 4:00 P.M. netasset value calculation, it may not be called a NAV calculation whendistributed to the market because of the issue of liability for any dataor calculation errors and because investors cannot necessarily buy orsell shares from the fund at that price. In addition, 4:00 P.M. closingprices are subject to verifications that may not be practical in anintra-day calculation.

[0038] The NAV proxy calculation could be used in a process to provide ahedging portfolio. Alternatively, the calculation used in a hedgingportfolio could be provided by the advisor, custodian, fund manager,etc. without encrypting or transmitting any data. Specialists and marketmakers manage their positions over the course of a trading day,generally to maintain either a market neutral or fund share risk neutralposition or a specific level of exposure that is independent of supplyand demand for the shares they are trading.

[0039] In the case of an index fund, the specialist or market maker thatsells shares to a public shareholder who comes to the market to buy may,at the same time as the fund share sale occurs, buy stock index futurescontracts or an index equivalent basket of stocks or other instrumentsto maintain a consistent degree of exposure. However, an activelymanaged or enhanced index fund will not be as readily hedgeable using asingle benchmark index/stock index futures contract as an index fund andthe contents of the fund may be partly or completely unknown to thespecialist or market maker.

[0040] Referring to FIG. 5, in one embodiment, the specialist does notknow what is in the portfolio because the valuation is calculated fromencrypted data in the trusted system 41. A hedge creation process 80sends 82 the portfolio to another trusted process in the computer 11 orto another computer having a trusted process. In any event, the trustedprocess extracts 82 factor information from the portfolio and applies 84factor analysis to the extracted portfolio information.

[0041] Factor analysis, as described, for example, in the followingpapers: M. A. Berry, E. Brumeister and M. B. McElroy, “Sorting Out RisksUsing Known APT Factors,” Financial Analysts Journal 44 (1988), 29-42;K. C. Chan, N. F. Chen and D. Hsieh, “An Exploratory Investigation ofthe Firm Size Effect,” Journal of Financial Economics 14 (1985),451-471; B. A. Rosenberg, “Extra-Market Components of Covariance inSecurity Returns,” Journal of Financial and Quantitative Analysis 9(1974), 263-274; S. Beckers, R. Grinold, A. Rudd and D. Stefek, “TheRelative Importance of Common Factors Across the European EquityMarkets,” Journal of Banking and Finance 16 (1992), 75-97; J. K. Kale,N. H. Hakansson and W. G. Platt “Industry Factors versus Other Factorsin Risk Prediction,” working paper, University of California, Berkeley(1991); E. F. Fama and K. R. French, “Common Risk Factors in the Returnsof Stocks and Bonds,” Journal of Financial Economics 33 (1993), 3-56; B.Lehman and D. A. Modest “The Empirical Foundation of the ArbitragePricing Theory” Journal of Financial Economics 21 (1988), 213-254; andG. Connor and R. A. Korajczyk “A Test for the Number of Factors in anApproximate Factor Model”, Journal of Finance 48 (1993), 1263-1292, canbe used to analyze how various factors have an effect on pricing of theunderlying portfolio. These papers are incorporated herein by reference.

[0042] The factors that are examined by applying 84 factor analysisinclude factors such as economic activity, inflation rates, industrymembership growth value linked behavior or other factors that arerelated to measures of security price behavior.

[0043] As an example, the specialist can be provided with a portfolio ofe.g., 100 financial instruments and information of appropriateweightings of each of the instruments. Each of the 100 financialinstruments will have distinctive factor characteristics. That is, someof the financial instruments are more interest sensitive, some are moreinflation sensitive, some are more sensitive to industrial production,or to any one of a number of other economic and financial marketvariables.

[0044] The process 80 constructs 86 a factor weighted portfolio byselection and weighting those 100 instruments based on results ofapplying 86 factor analysis. Ideally, the factor-based portfolio wouldbe virtually identical in market performance to the exchange tradedfund. The performance expectation would be based on historicrelationships, as analyzed by the factor model. The specialist andmarket makers are given a list of instruments and the proportions ofeach instrument needed to take risk offsetting positions to hedge anylong or short position they may be called upon to take in the shares ofthe fund. The traders would use that information to create 88 a hedgingportfolio.

[0045] While the hedging portfolio will not be identical in performanceto the fund nor will it conform as closely to the fund performance as anindex basket or instrument does with a fund based on an index,nevertheless, the hedging portfolio should track the exchange tradedfund portfolio closely enough over the course of a trading day or even along period of time to protect the trader from major losses. The hedgingportfolio would be updated daily to reflect changes in the compositionof the fund portfolio. These hedging portfolios need to be liquid sothat the specialist can convert the position to cash or some particularportfolio (that can be used as a creation basket for the fund) at theend of the day.

[0046] The hedging portfolio can also be used to calculate a Net AssetValuation proxy much like that described above. However, rather thanusing actual positions in the exchange traded fund, the NAV process willuse the positions in the hedging portfolio and apply current prices tothose positions along with their weightings in the hedging portfolio todetermine a NAV proxy value. The hedging portfolio used need not beidentical to the actual hedge portfolio since the hedge portfolio mightnot take positions in certain securities since there might not be aliquid enough market for the security and so forth.

[0047] Referring to FIG. 6, a variation of the stand-alone hedgingportfolio described above is shown. This process 90 receives 91 anin-kind creation basket that is posted or provided by the fund orinstrument that the trader trades. The trader would produce 93 asupplemental hedging portfolio or basket as described above. The traderthus would include this supplementary hedging portfolio as an add-onportfolio to be used in conjunction with the in-kind creation basketposted by the fund. In this case, the trader combines 95 a position inthe creation (redemption) basket with a position in a supplementaryhedge basket. At some point during trading, the trader could tender 97(or receive) the creation (redemption) basket to adjust its fund shareposition at the end of the day and close out the supplementary hedgeportfolio at the close.

[0048] To explain this process in more detail, a creation basket for anactively managed fund may not exactly match the portfolio and thus, itmay not be suitable as a stand-alone hedging basket. The creation basketmay be different from the fund portfolio to various degrees and, thus,the creation basket may not closely track the actively managed fund onan intra-day basis. Thus, rather than the specialist using the creationbasket alone as a hedging instrument, the trader could use the factorportfolio process described above or a combination of the creationbasket and the supplementary hedging basket produced by the factorportfolio process, because the trader may need a creation basket at theend of the day to exchange for the fund shares. The trader would need toclose out the supplementary hedging basket in a very low cost mannerperhaps using market-on-close-orders. This is another feature providedto traders for use in hedging their positions.

[0049] These features are designed to make markets tighter (i.e., lowerspreads between bid and asked prices) and to provide services whichencourage people to list their funds on the exchange. To the extent thatan intraday net asset value proxy is determined, it enables thespecialist to know the appropriate price for shares that the specialistbuys and sells over the course of the day. The investor can know thatthe market is fair and that bid and offer prices tightly bracket theintraday net asset value proxy. The intraday NAV proxy process describedabove processes such data for an actively managed, exchange traded fundfor which the actual positions in the fund are not known outside of thefund management organization.

[0050] The hedging portfolio reduces the risk that the market maker orspecialist takes because there is a basket, that is the hedgingportfolio, that closely approximates the behavior of the exchange tradedfund on the long side of the market when the specialist shorts theshares or on the short side when the specialist sells the hedgingportfolio (short) to hedge a long position in the fund shares.

[0051] With this hedging portfolio, the exchange facilitates riskmanagement for the specialist and replicates the risk as closely aspossible to the risk that the trader is accepting. The hedging portfoliominimizes but does not eliminate tracking error. The hedging portfolioenables the specialist or market maker to hedge its portfolioefficiently at a lower cost than they could do with no more than thefund's last reported portfolio because that portfolio could easily besix months or more out of date.

[0052] The factor model provides the specialist or market maker with aportfolio of instruments, securities, etc. that will enable thespecialist to create a hedge that will track the basket of securitiesthat make up the exchange traded fund portfolio without the specialistever knowing what specific securities are in the fund.

[0053] The encrypted information is used to extract factors that affectthe value of the securities that make up the exchange traded fund. Theexact process will depend on the type of factor model used. Assume thata Sharpe-type factor model is used. The Sharpe model will take anexisting portfolio back in time (not the actual portfolio that was inthe fund in the past because the actual portfolio may change from day today, but the actual portfolio at the prior day's close as if thatportfolio had been in the fund all along).

[0054] Referring back to FIG. 5, the process 80 takes a potentialhedging portfolio of, e.g., 100 instruments, and executes a computerimplemented model to determine weights, if any, in each of theseinstruments to give the best possible tracking of the actual fundportfolio. The specialist or market maker who needs to hedge a positionis provided with the appropriate weighted portfolio of instruments whichwould have tracked that portfolio very closely or to a specific degreeof tolerance or tracking error over the prior period. This informationis used by the specialist or market maker to produce a hedging portfolioto offset the risk of shorting the fund shares when there is more demandfor the fund shares than the traders can supply from inventory, or goinglong the fund shares and short the hedging basket when there is lessdemand for fund shares and the traders must absorb fund shares intoinventory.

[0055] Thus, the net asset value proxy calculation and the portfolio ofhedging instruments provide additional information for specialists andmarket makers on the floor to enable them to make better markets. Whilethis information may not be disseminated to market makers in othermarkets due to economic, regulatory and liability factors, the existenceof the information should make these markets better (deeper and with atighter spread) as well.

[0056] Unlike a synthetic hedging portfolio that is based on historicalclosing NAV while keeping the contents of the portfolio confidential,the hedging basket, to be effective, must be based on the currentportfolio. In the synthetic hedging portfolio, only the closing NAVcalculations are used. Back over a period of time, these calculationsbecome less relevant to the current contents of the portfolio.Furthermore, to the extent that the portfolio changes in a material way,net asset value calculations from even a few days earlier may give amisleading picture of the investment characteristics of the portfolio.

[0057] Referring to FIG. 7, an alternative process 100 for a marketmaker or specialist to hedge a portfolio is shown. The alternativeprocess calculates 102 an NAV history for the actual portfolio (as ofthe previous day's close). The process 100 prepares and disseminates 104a hedging portfolio for the use of the specialist, market makers and,perhaps, arbitrageurs interested in creating a hedging position. Theprocess 100 could be executed by the fund custodian or advisor or by theexchange using an encrypted portfolio much the same way that the NAVproxy calculation is determined. The process 100 would price thatportfolio using a price database. As long as the instruments to beevaluated and included in the recommended hedge and the technique usedare known in advance, it should be possible to reduce tracking error.The entity that prepares and disseminates the hedging portfolio reports106 a correlation or the tracking of the hedging portfolio with the fundportfolio. In order to determine tracking error, the entity needs actualknowledge of the portfolio as it exists at the previous night's close.

[0058] In general, such a hedging portfolio would be fairly constant,unless and until there was a material change in the contents of the fundportfolio, at which time the hedging portfolio would probably change.Changes in the hedging portfolio could result from a broad change in theunderlying portfolio, e.g., a shift from technology stocks to financialstocks. Disseminating information on specific portfolio changes mightnot be acceptable to the advisor. Rather, the advisor may choose toaccept the cost of not providing a close tracking hedging portfolio,recognizing that the cost will include wider spreads and, probably, lessliquidity in fund shares in the market.

[0059] The hedging portfolio, a variation on full dissemination of theportfolio, will be acceptable to many fund advisors. A participant whowas considering creating or redeeming shares would look at a creation orredemption basket as part of the hedging position. The rationale for theredemption basket is that if the market maker or arbitrageur sought toredeem the basket, the portfolio he would receive would be for theredemption basket and would in many cases be different from the actualfund portfolio and from the creation basket. To the extent that thecreation or redemption basket does not match the fund portfolio, theadvisor or fund manager can add additional instruments (i.e., thesupplementary hedging basket to the creation or redemption basket) toimprove tracking. The additional instruments could be provided toimprove the tracking of the entire hedging position. The additionalinstruments could improve tracking for various market participants,particularly those engaged in arbitrage and market making, will helpimprove the quality of their hedges, and should have the highlybeneficial effect of reducing the bid-asked spread.

[0060] This alternative approach to producing a synthetic portfoliousing a factor model or other technique has several advantages. Thesynthetic hedging portfolio might include a mixture of futurescontracts, options and/or a number of stock positions that collectivelymirror the historic behavior of the current portfolio. Using any ofseveral types of factor models, the buyer can develop a hedgingportfolio that will be more highly correlated with the fund than anysingle futures contract.

Other Embodiments

[0061] It is to be understood that while the invention has beendescribed in conjunction with the detailed description thereof, theforegoing description is intended to illustrate and not limit the scopeof the invention, which is defined by the scope of the appended claims.Other aspects, advantages, and modifications are within the scope of thefollowing claims.

What is claimed is:
 1. A method of hedging investment risk in activelymanaged exchange traded funds, comprises: extracting factor informationfrom the portfolio of the actively managed exchange traded fund;determining factors that affect the value of the exchange traded fund;and selecting a portfolio of financial instruments with similar behaviorwith respect to the determined factors to produce a hedging portfoliothat tracks the price of the exchange traded fund.
 2. The method ofclaim 1 wherein the portfolio tracks the price of the exchange tradedfund.
 3. The method of claim 1 further comprising: producing a hedgingportfolio from the portfolio of financial instruments to hedge aposition taken in the exchange traded fund.
 4. The method of claim 1wherein determining further comprises: applying factor analysis to theportfolio of the exchange traded fund to provide the factors.
 5. Themethod of claim 3 wherein applying occurs in a trusted computer system.6. The method of claim 1 wherein the factors that are examined by factoranalysis include economic activity, inflation rates or other factorsthat are related to measures of economic activity.
 7. The method ofclaim 1 further comprising: constructing a factor portfolio based uponweightings and selections of securities from a given group ofsecurities.
 8. A computer program product residing on a computerreadable medium for hedging investment risk in actively, managed,exchange traded funds, comprises instructions for causing a computer to:extract factor information from a portfolio of the actively managedexchange traded fund; determine factors that affect the price of theexchange traded fund; and select a portfolio of financial instrumentswith similar behavior with respect to the determined factors to producea hedging portfolio that tracks the price of the exchange traded fund.9. The computer program product of claim 8 wherein the portfolio tracksthe price of the exchange traded fund.
 10. The computer program productof claim 8 further comprising instructions to: produce a hedgingportfolio from the portfolio of instruments to hedge a position taken inthe exchange traded fund.
 11. The computer program product of claim 8wherein instructions to determine further comprise instructions to:apply factor analysis to the portfolio of the exchange traded fund toprovide the factors.
 12. The computer program product of claim 11wherein instructions to apply are executed in a trusted computer system.13. The computer program product of claim 8 wherein the extractedfactors that are examined by factor analysis include economic activity,inflation rates or other factors that are related to measures ofeconomic activity.
 14. The computer program product of claim 8 furthercomprising instructions to: construct a factor portfolio based uponweightings of and selections from a given group of instruments.
 15. Acomputer system for determining a basket of securities for hedginginvestment risk in actively managed exchange traded funds, comprises: atrusted computer system; and a computer storage medium storing acomputer program product for determining the basket of instruments forhedging investment risk, comprising instructions for causing thecomputer to: extract factor information from a portfolio of an activelymanaged exchange traded fund; determine factors that affect the price ofthe exchange traded fund; and select a portfolio of financialinstruments with similar behavior with respect to the determined factorsto produce a hedging portfolio that tracks the price of the exchangetraded fund.
 16. The system of claim 15 wherein the computer programfurther comprises instructions to: produce a hedging portfolio from theportfolio of stocks to hedge a position taken in the exchange tradedfund.
 17. The system of claim 15 wherein instructions to determinefurther comprises instructions to: apply factor analysis to theportfolio of the exchange traded fund to provide the factors.
 18. Thesystem of claim 15 wherein system examines factors including economicactivity, inflation rates or other factors that are related to measuresof economic activity.
 19. The system of claim 15 wherein the computerprogram further comprises instructions to: construct a factor portfoliobased upon weightings and selections from a given group of instruments.20. A method of calculating a Net Asset Valuation proxy comprises:producing a hedging portfolio to track an actively managed fund byextracting factor information from a portfolio of the actively managedexchange traded fund and determining factors that affect the price ofthe exchange traded fund to select a portfolio of financial instrumentswith similar behavior with respect to the determined factors to producethe hedging portfolio; and applying current prices to the hedgingportfolio to determine a NAV proxy value for the exchange traded fund.